While the long-term benefits of technology are undeniable, managers are increasingly concerned about ...
Edgar van Tuyll, strategiest at Pictet, says: "As the incredible valuations reached on internet stocks cannot be explained by expected earnings figures or by the level of interest rates, many have started to believe in magic - that as internet stocks belong to a 'new economy', they are not subject to conventional rules. In fact, the situation seems in line with situations in the past when high-return sectors have challenged conventional wisdom. A common feature has been these sectors' very strong relationship with excess liquidity. The relation between excess liquidity and the stock market is replaced by one between excess liquidity and these sectors. When excess liquidity increases these sectors shoot up and when it dries up they come tumbling down again."
Examples of this phenomenon include biotech companies in 1995-6, Japanese real-estate-related sectors in the late-1980s and the US 'Nifty Fifty' in the early 1970s.
Van Tuyll says: "By excess liquidity, we mean a situation where credit grows faster than the economy. There are several ways to measure this notion. We estimate it by the ratio between commercial bank credit and nominal GDP, using the coincident index of the business cycle multiplied by the CPI as a proxy for nominal GDP. Statistical tests indicate that a strong long-run relationship exists between variations in excess liquidity and the 'flavour of the year' in high-return sectors; in this case, internet stocks."
At the start of a typical bull market, van Tuyll said, inflation and interest rates are falling. "This increases credit and economic growth. Stock markets start to rally and a new bull market begins to develop. At a certain point, usually after a lengthy period of economic expansion, a growing appetite for risk can be observed and long-term rates go up as people sell bonds and push their prices down. Markets turn to the 'flavour of the month' stocks.
"When short-term rates hit the bottom, markets start to worry about a pickup in inflation and long-term rates start to rise, a trend accelerated by brisker demand for investment capital. Two things can happen. The entire market could still rise if expected earnings growth in a majority of sectors is strong enough, or the breadth of the market can start to narrow, with only a limited number of companies going up. All the excess liquidity then becomes concentrated on a limited number of stocks."
Excess liquidity should fall, van Tuyll says, when the main central banks decide to raise official interest rates as Pictet forecasts they will for the next few meetings. "Unfortunately, the relationship between excess liquidity and official rates is very unstable."
Peter Toogood, manager of the Forsyth Technology fund of funds, agrees that the market is seeing extraordinary polarisation which will eventually end, but the momentum is such that the end is difficult to call.
"It is clear that yield is no longer loved in the major markets. However, a number of mainstream managers have told us that they are forced to hold the prevailing 'TMT' theme because not many other models seem to offer the same prospects for top-line growth. The problem is exacerbated because at the same time as these managers are loading up on 'new economy' stocks, they are dumping 'old economy' stocks, which are further de-rated.
"The question of who will be the beneficiaries of the technological boom is a hard one. Business-to-business system providers have had their share prices inflated by the promise of ongoing revenues. However, it seems likely from the recent deal between Ford, GM and Daimler Chrysler that the incumbents will benefit but the enabler will be likely to be cut out of the loop."
Nevertheless, Toogood does not see any imminent collapse in the 'new economy' stocks: "There is so much money waiting to pour into this area. The key is to focus on the business model of the individual company, looking at its future viability, and seeking to understand what the company is doing. This process of stress-testing is where managers can add value and, by displaying this type of rigour, they are able to be as defensive as possible in the face of the overwhelming momentum this area continues to show."
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